Inflation ’06: Up, Up and …

Why are so many people concerned when Fed Chairman Ben Bernanke acts on iflation as he did last week? Inflation not only affects individual purchasing power, but corporate fundamentals as well. For example, rising inflation rates tend to artificially inflate corporate earnings while causing P/E ratios to shrink and distort historical comparisons.

However, few investors understand the context in which current inflation trends are taking shape, or the implications for asset allocation and portfolio construction. In fact, flat or mildly positive inflation along with modest interest rate increases are likely indications of the economy's underlying health, reflecting an environment of steady growth that may well prove advantageous to stock and bond investors over the long-term.

Inflation is simply the overall rate at which the prices of an economy's goods and services are increasing. Though relatively easy to define, inflation can be difficult to measure precisely, since it involves such a broad range of goods and services, prices of which continually shift at different rates in relation to each other. The federal government uses several yardsticks to quantify inflation from various perspectives.

The most widely followed barometer of inflation is the Consumer Price Index, produced by the Bureau of Labor Statistics. The CPI tracks out-of-pocket price changes for a fixed basket of urban household purchases. Since the list of goods and services comprising the CPI and their relative weights are rarely revised, the index is slow to react to marketplace changes.

Another fixed-weight index produced by the Bureau of Labor Statistics, the Producer Price Index, measures prices at the wholesale or producer level. It is considered a leading indicator since a rising PPI is typically followed by a higher CPI, as producers seek to pass along higher costs to consumers.

Finally, the Personal Consumption Expenditures Deflator, produced by the U.S. Bureau of Economic Analysis, is the inflation measure of choice for setting U.S. monetary policy. It is a "chain-weighted index," reporting price movements on a basket of goods and services that is constantly evolving as demand rises and falls, and as consumers make product substitutions due to price changes.

Because the PCE's components and their relative weights reflect changing consumer demands, it is widely considered to be the truest barometer of broad consumer inflation.

Each of these inflation indices can be refined to meet specific analytical needs. For example, the core PCE excludes food and energy items, which account for roughly 20 percent of the total PCE.

A Clear Picture
The removal of volatile food and energy components from the index is thought by Fed policy makers to produce a more accurate picture of underlying trends in consumer price inflation.

Taken together, the various yardsticks provide a picture of general long-term trends. Over the last 50 years, inflationary pressure clearly increased from the late 1960s through the early 1980s and on through 2003.

However, it becomes difficult to differentiate between short-term volatility and long-term trends across a shorter time frame, particularly when the data offers contradictory evidence.

For example, the core CPI indicates that inflation eased during 2004. It remains a matter of interpretation whether these developments point to short-term volatility or indicate a long-term trend.

While direct energy costs are excluded from core inflation indices due to oil and gas price volatility, sustained high energy costs eventually ripple through the economy, driving production costs up across a wide range of industries.

Rising labor costs elicit similar effects, while the declining strength of the U.S. dollar relative to currencies of other countries tends to drive up important prices.

On the other hand, intense global competition has prompted companies to avoid passing most price increases on to consumers. Instead, producers have absorbed additional costs by increasing productivity and reducing profit margins.

When viewing the entire picture, these realities lead most forecasters to anticipate mildly rising inflationary pressures for the foreseeable future. The Fed has demonstrated its own concurring view by implementing a series of measured, short-term interest rate increases designed, in part, to combat inflation (like it did last week).

Observers of the international economic scene have doubtless taken note of more recent examples of the hyperinflation that has afflicted some of our South American neighbors. Even short of these extremes, it's not hard to see why prolonged periods of high inflation cause concern for both bonds and stocks.

Today, however, most financial analysts view inflation as benign. A healthy economy that is expanding at a reasonable level needs a certain amount of price growth.

Economists have pegged the "right" amount of inflation at about 2 percent to 3 percent per year, a target well-aligned with current levels of the core CPI and core PCE.

Craig Langweiler is president of the Langweiler Financial Group, in Newtown. He can be reached at 215-860-8088 or at: [email protected]



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